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How to Choose a Self-Employed Retirement Plan

The first step to deciding which retirement plan to choose for your self-employment income is figuring out the amount that you think you will be able to contribute. From that point, then you can choose which vehicle may work best for you.

The three basic tiers are the following:

  • $6,000
  • 25% of compensation(up to $58K for 2021)
  • $20K plus about 25% of compensation(up to $58K for 2021)

First tier-$6,000

If you have decided that you are in this first group with $6,000 to contribute to a retirement plan, then most likely a Traditional IRA or ROTH IRA is your best option. If you are age 50 or older, then you can contribute an additional $1,000 as a catch-up contribution bringing you to $7,000 for the year.

  • Traditional IRA is tax deferred-no tax on those dollars now, but fully taxable at the Federal and most State levels when you take the money out.
  • ROTH IRA is after tax dollars-all dollars are taxed at the current year rate and tax free upon distribution if you meet the rules.

Both contributions are due by the earlier of April 15th or when you file your tax return for the year.

Second tier-25% of compensation

If you can contribute 25% of your compensation, then a SEP IRA could be a good option for you. You have until the due date of your tax return including extensions to contribute to the SEP IRA. This gives you a little more time to max out this vehicle if you need it. The maximum limit is $58K for the year. All this contribution is tax deferred-so no tax due now, but fully taxable when taking the money out. If you have employees, you must also contribute for them.

Third tier-$20K plus 25% of compensation

You may be wondering why this third tier is even an option if the same $58K limit applies like the second tier. This option would be an Individual K. There are a few additional rules and figuring out the maximum amount is calculated differently. In other words, you may be able to contribute more than just 25% of your income if you are under 232K of compensation (25% of $232K is $58K). First rule for an Individual K is that you cannot have any employees (spouse being an exception, but they must be a legitimate employee).

The contribution is broken out into two pieces: EmployEE Deferral and EmployER non elective contribution. The Employee Deferral piece has the same limit as a 401k plan-for 2021, $19,500 or $26K if age 50 or older. This deferral piece is not tied to a percentage which is how you can put more away than the tier 2 piece above at certain income levels. The second piece of the contribution is tied to a percentage of compensation-approximately 25%.

The maximum contribution is $58K for 2021. If you can contribute the full $58K, why would you choose the Individual K option? You can set up the Individual K to allow for ROTH contributions. This means you can have both after tax contributions (ROTH EmployEE Deferral) and tax deferred contributions (EmployER contributions). Essentially you are splitting the tax burden. One more important caveat with this Individual K is that the plan must be set up by 12/31 of the current tax year. You cannot open the account and fund it when you are filing your taxes. The plan must open and theoretically you are funding the employee deferrals throughout the year. The employER portion of the contribution can be funded by the due date of your tax return including extensions.

The moral of the story is to think about which plan is appropriate for you before the end of the tax year so you can open an Individual K if necessary.

If you would like to further discuss some of these options, please reach out. These are things we help our clients with each year.

Financial Journey LLC is a registered investment advisor offering advisory services in the state of Virginia and in other jurisdictions where exempted. Information provided is for educational purposes only and not, in any way, to be considered investment or tax advice.

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